'Serenity now, insanity later': Credit Suisse thinks Australia's economy could be on the verge of a sharp slowdown that will cause all sorts of trouble

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  • Australia’s economy grew at an annualised pace of more that 4% in the first half of 2018. The RBA expects growth will remain strong in the coming years.
  • Credit Suisse has taken a different view, warning the recent growth spurt has been driven by unexpectedly strong infrastructure investment. It doesn’t expect that will continue in the year ahead.
  • Given risks associated with housing construction and household spending from the downturn in property market, a pullback in infrastructure spending could easily see the RBA drop its view that the next move in official interest rates is likely to be “up”.

Australia’s economy is humming like a well-oiled machine in 2018, growing at an annualised pace of more than 4% in the first half of the year.

It’s been a stellar and somewhat unexpected rebound following sluggish growth last year, helping to fuel optimism about what lies ahead for the economy, including from the Reserve Bank of Australia (RBA).

However, if you’re extrapolating recent trends out over the longer term, be prepared for disappointment, says Damien Boey, Research Analyst at Credit Suisse.

He says economic growth is likely to slow quite sharply in the coming quarters, raising the prospect that the next move in official interest rates may not actually be higher as the RBA currently expects.

“Our view is that the economy is overshooting,” Boey says.

“We believe that growth will eventually slow as timely leading indicators [such as PMIs] are suggesting.”

Boey says the recent surge in economic activity has partially been driven by an large lift in infrastructure investment.

“We think that the [economy] is still being supported by infrastructure,” he says.

“The latest Access Economics data for Q3 suggest that growth in the stock of infrastructure spending has re-accelerated. And recently, project spending growth has been remarkably positively correlated with the cycle in domestic demand.”

However, while actual infrastructure investment has been strong, Boey doesn’t expect that trend will last based on new projects in the pipeline.

“In 2018 to date, actual project spending growth has accelerated, even as the project pipeline has thinned out,” he says, pointing to the chart below that shows the annual change in actual infrastructure investment against the expected pipeline ahead.

Credit Suisse

“It is in this sense that we think infrastructure spending growth has been overshooting, contributing to the overshooting we are also seeing in domestic demand growth relative to leading indicators,” Boey says.

“However, the more growth in spending we experience today, the more we also eat into future growth, unless policy makers are able to adequately top up the project pipeline.

“As the saying goes, ‘serenity now, insanity later’.”

So the unexpected boom in infrastructure investment in 2018 is creating a high base effect for growth rates in the future, a factor Boey believes will see the economy decelerate next year, particularly given risks surrounding the household sector and housing market.

“Our concern is that the economy is very much driven by housing and consumption,” Boey says.

“Indeed, the multiplier effects of housing on the rest of the economy are very large. In this respect, conditions do not look particularly healthy.”

And should infrastructure spending cool over the next year, Boey says households could adopt a risk averse mindset, compounding the potential downturn further.

“Infrastructure spending is providing a circuit breaker between falling house prices and the aggregate spending. Employment growth has been remarkably resilient, allowing households to absorb negative wealth and credit effects from housing downturn,” he says.

“But if the infrastructure pipeline is not topped up in a timely fashion, the risk is that the public spending impulse will fade, employment growth will slow, and private sector de-leveraging forces will take over.”

At a time of falling home prices in many parts of the country, Boey also warns this could see “residential investment fall materially”.

Boey, like many other forecasters, thinks the Sydney-led national housing downturn will continue for sometime yet, forecasting that home prices in Australia’s largest and most expensive city will fall 10% this year and next, with potential downside risks.

While he admits his views on the economic outlook subject to the risk that “policymakers respond either by cutting rates or increasing deficit spending in the right areas,” in the absence of such moves, unlikely when it comes to monetary policy, few will disagree with Boey that there is a large degree of uncertainty about the outlook for household spending and residential construction in the years ahead.

And that includes from the RBA.

In the bank’s quarterly Statement on Monetary Policy (SoMP) released last week, it acknowledged that despite forecasting GDP growth of well above 3% this year and next, there were still many questions that are yet to be answered.

“There continues to be uncertainty about how quickly the unemployment rate will decline and how quickly that will feed into wage pressures and inflation,” it said.

“Uncertainty about wages growth also translates into uncertainty about the outlook for household disposable income, which has a direct bearing on consumption growth, as does the evolution of housing prices through household wealth.”

In a separate speech delivered earlier this week, RBA Deputy Governor Guy Debelle also waned about the potential impact that tighter lending standards for home borrowers may have on property developers, and hence the outlook for residential construction.

“One risk is that tighter lending standards could amplify the downturn in apartment markets if some buyers of off-the-plan apartments are unable to obtain finance,” Debelle said.

“This could lead to an increase in settlement failures, further price falls and even tighter financing conditions for developers.”

Under such a scenario, it’s unlikely that residential construction will remain anywhere near as strong as the RBA currently expects, casting doubt over the prospect of strong economic growth, lower unemployment and a pickup in wages in the years ahead.

While these are all potential risks, not a certainty, should the economy start to splutter as Boey expects, it’s unlikely the RBA will retain the view that the next move in official interest rates will be higher.

Given the starting position for inflation and wage pressures, it would almost certainly require additional policy support.

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